There exist many methods of trading securities through automated systems. These systems may be operated by exchanges, automated trading systems (“ATS's”) and electronic communications networks (“ECN's”). These systems bring counterparties together largely by publishing firm prices (“quotes”) by market makers, exchange specialists, and institutional customers. These prices are usually displayed in what is known as the Consolidated Quote System (“CQS”) or National Market System (“NMS”) or on other private networks, but in either case are broadly disseminated to multiple parties simultaneously, as well as carried by market data vendors that also broadly display such prices.
By and large, these systems have been effective at posting and executing orders of relatively small size. Participants with larger orders (“blocks”) are disincented from using such systems, however, because of the likelihood that such broad, public display of large orders would tend to have negative market impact, and subject the holder of such orders to the risk that prices will move against them.
This disincentive has become particularly acute with the move to decimalization in the last few years, which has had a marked effect on trading behavior. A reduction in the amount of liquidity that participants are willing to show (display) as a result of decimalization has been observed in U.S. securities markets. For example, it has been observed that participants who do use existing automated systems for large orders are forced to break up the order into smaller portions, in an attempt to remain anonymous both as to their identity and as to the size of their true orders. Thus an institutional customer seeking to buy or sell a large block of stock (e.g. 100,000 shares) would not want to publicly advertise this in the form of a public quotation on an exchange or via a market maker's quotation, nor would they want to post an order of that size on an ECN, which also would be displayed in the CQS or NMS for all participants to observe. Instead, such a customer must often break the order up into many individual lots and post them in multiple venues or feed them into the market slowly over a period of time so as not to “move the market” to their detriment. This raises the cost of handling such orders, and inhibits the process of filling the entire order at a single, known price quickly and efficiently.
As a result, at least some larger orders are submitted to an exchange floor, to be “worked” by a floor broker in a manual fashion requiring a high degree of human interactivity and judgment, with its attendant problems such as “information leakage,” human error and higher handling costs. In the alternative, such larger orders also may be “shopped” to dealers in the over-the-counter (“OTC”) market (also called market makers or “block positioners”) who often are willing to commit their own capital to the order, or assemble other counterparties away from an exchange floor, helping the customer receive an acceptable price. This too is largely a manual process, requiring dealers to negotiate verbally with the customer or other counterparties, and also may be subject to information leakage and error.
From the dealer's perspective, this process also is difficult to manage because of the risk that always is involved when a dealer commits its own capital to a transaction. In order to manage this risk effectively, the trader committing this capital must synthesize many pricing factors during the negotiation in order to establish the ultimate transaction price that is not only acceptable to all parties, but also consistent with a variety of risk parameters that may be established by a dealer when going “at risk” by committing its own capital.
At the same time, because of the collapse of the typical displayed bid-ask spread resulting from decimalization and other regulatory changes in the past few years, those dealers who are willing to commit their own capital at a price have reduced the amount of capital (liquidity) they may be willing to commit, whether it is in the form of their proprietary quote in the public CQS or NMS system or even when negotiating in a manual process when dealing with a customer.